Modern Monetary Theory and mainstream economics converging
Stephen Grenville gives a detailed account in the Eureka Report on Modern Monetary Theory (MMT), which after a decade on on the periphery of economic discussion, has recently surged in popularity.
Modern Monetary Theory (MMT) has been on the fringes of economic discussion for a decade or more, but it has recently moved from the periphery to become part of the everyday discussion. Why this new-found popularity, and what might it mean for economic policy?
The shift in interest pre-dates the COVID-19 crisis, but the virus has given MMT a huge boost. Governments around the globe have been quick to dramatically expand their budgets in response to the crisis, with deficits of 10 per cent of GDP becoming routine.
Economists, even those who have spent a lifetime warning of the perils of budget deficits and government debt, seem to accept these astronomical deficits with equanimity. Stranger still, central banks everywhere are abandoning time-honoured conventions and funding these budget deficits to a greater or lesser degree by buying government bonds – what is often called ‘printing money’. This seems to be the same as the MMT core message – run deficits to maintain full employment and fund them by money-printing. Mainstream economists are adamant that they are not supporters of MMT, although just where they disagree is sometimes unclear.
To explain this radical rethink of economics we have to go back well before COVID-19, to the global crisis of 2008. But first, we should try to set out the precepts of MMT, to see where these fit with the narrative of economic thought.
1. Attempting to clarify MMT
Different adherents emphasize different aspects of MMT, and in defending their views, some may have taken positions that would not be supported by all MMT proponents. They have made their case in a sceptical world, and have elided over some of the trickier aspects. But what follows seems to capture the essence of MMT.
The most appealing part of the MMT story, especially for a general audience, seems to be identical to the Keynesian viewpoint that dominated the economics profession for the first three decades of the post-WWII era. The economy was subject to business cycles and these could be smoothed by the application of counter-cyclical budget policy, boosting expenditure to achieve and maintain full employment. There were limits to the economy’s capacity to produce, and if these were exceeded, inflation would result. But active counter-cyclical fiscal policy could mitigate – perhaps even banish – recessions and depressions.
In the 1970s and 1980s, this mainstream conventional wisdom came to be doubted, mainly because the 1970s experience of ‘stagflation’ – inflation rose even though unemployment was significantly higher than it had been in the immediate post-war decades. The blame was put on excessive budget deficits, excessive government debt and too much money creation.
Milton Friedman convinced just about everyone that inflation was ‘always and everywhere a monetary phenomenon’. Meanwhile, the Thatcher/Regan revolution was preaching the ‘small government’ creed – that governments should do as little as possible. Budget deficits would push up interest rates (the ‘bond market vigilantes’ were waiting to ensure this), crowding out useful private-sector expenditure. In these circumstances, the Keynesian budget multiplier was close to zero. Not much could be done to dampen the business cycle, as monetary policy had to focus on inflation control.
MMT has revived the old Keynesian message: if the economy has spare capacity, governments should expand the budget to bring the economy back to full employment. Certainly, policy measures shouldn’t push this beyond the economy’s productive capacity, or inflation would result.
But what about the arguments that had undermined this Keynesian narrative in the 1970s – that deficits would not provide effective stimulus because the deficit-financing bond sales would drive up interest rates and crowd out other expenditure, leaving no net stimulus?
The MMT proponents argue that if the government bond issue raises interest rates so as to crowd-out the deficit stimulus, the government should instead fund its deficit by using the money-creation capacity of the central bank.
Perhaps they are a little vague, even slippery, on the detail here, as this is the chief vulnerability of the MMT narrative. The government might get the cash to spend in its deficit by giving the central bank a bond in return for the cash. But the bond is just a government debt which it owes to itself, so in the view of many MMT supporters, the bond could be deleted from the central bank balance sheet by offsetting book entries in the accounts of the government and the central bank.
In spending the cash to implement its deficit, the government shifts the economy to full-employment. Inflation doesn’t increase, as the economy had spare unused capacity and the deficit expenditure puts no pressure on productive capacity. GDP has increased without either debt or interest rates rising. This seems to be ‘free money’.
It’s hardly surprising that this is an attractive narrative, both to those who see unemployment as a social evil and those who see benefit in a larger role for government, providing a greater range of services and investments. It is particularly attractive to those who look to Scandinavian countries as examples of successful economies where the government plays a large role. So why isn’t everyone signing up to the MMT message?
‘Follow the money’, the detectives say. For simplicity, let’s assume the deficit expenditure is in cash. This circulates in the economy, stimulating demand and expanding GDP. Some of the cash will remain in the hands of the public in the form of extra currency balances, but most of it will end up in the banking system, as deposits. The banks don’t want to hold zero-interest cash, so they hand it back to the central bank, increasing the banks’ reserves at the central bank.
It is these banks’ reserves that are, in effect, funding the budget deficit. They are NOT free of interest cost, as central banks pay the banks a market-related interest return. And they DO increase official-sector debt – these reserves are a liability of the central bank to the banking system, and so should properly be counted as part of official debt.
In short, the core MMT promise, sometimes implicit, is interest-free financing which doesn’t add to official debt. This is clearly wrong. Milton Friedman got this much right: ‘there is no free lunch’.
2. Why the new interest in MMT?
Where does the MMT narrative fit within the development of the mainstream macro-economic thinking? The 2008 global financial crisis was the catalyst in bringing the MMT story towards the mainstream.
In 2008 the US Fed began quantitative easing (QE) in response to the seizing-up of the mortgage market in the nadir of the crisis, and continued QE for four years with the objective of lowering the yield curve. The common factor in these different objectives was that the Fed bought large amounts of government bonds, which it paid for in central bank cash. In the process, banks’ reserves rose, in the same way as described above.
The purpose here is not to debate the effectiveness of QE. Rather, it is to observe that central banks created huge increases of cash (central bank ‘base money’) through the purchase of bonds, and yet this was not inflationary. Universally, inflation remained below target. Friedman’s threat of ‘too much money chasing too few goods’ didn’t happen. Nor did the extra base money held by the banks cause them to increase their lending: bank credit actually fell in the major economies during the two years after the crisis. The banks had already made all the loans to bankable customers that they wanted to make, and they had nothing better to do with the excess base money other than to put it with the Fed in the form of banks’ reserves.
Thus the first element of the rethink of economics after 2008 was the recognition that central banks could buy government bonds, create base money, interest rates would fall rather than rise and inflation was unaffected.
The second element of the rethink was the role of government deficits. Most countries applied deficit stimulus in 2009, but within a year austerity was imposed through surplus budgets, motivated by concerns about government debt that had built up during the global crisis. With budget surpluses subtracting from demand, the recovery was lacklustre.
By 2013, some macroeconomists (such as Olivier Blanchard, then chief economist at the IMF) were recognizing that the austerity had been more damaging than expected. The Fund had advocated austerity, believing that the budget multiplier was low so the surpluses would not damage the recovery. By 2013, Blanchard recognized the error. The austerity was holding back the recovery.
By 2019 Blanchard went one step further, arguing that, with interest rates well below the rate of nominal GDP growth, governments could afford to run modest deficits without the debt/GDP ratio rising, with a strong implicit recommendation that they should do so. Even the IMF (whose surplus-promoting doctrines were so entrenched that its initials were widely quoted as standing for ‘It’s Mainly Fiscal’) was urging countries with ‘fiscal space’ to run deficits to promote growth.
Donald Trump’s company tax cuts in 2017, ill-conceived as they were, added weight to the evidence that budget deficits worked effectively to affect growth – the US recovery accelerated and unemployment fell to record-low levels. The huge expansion of Fed base money (‘money printing’) had no effect on inflation, and interest rates continued to fall, to historically low levels.
In short, the mainstream view that deficit spending was ineffective was shown to be wrong, at least in the context of an economy working at less than full capacity.
Other mainstream economists joined the re-think of macro-economics. Larry Summers called for substantial government expenditure on infrastructure to address the problem of ‘secular stagnation’ – another old idea revived almost a century after Alvin Hansen had first worried about the economy’s apparent inability to sustain growth.
Adair Turner, who headed the UK Financial Services Authority during the 2008 crisis, was an early (2015) convert to the heretical idea of ‘helicopter money’, essentially the same as MMT. With monetary policy and conventional fiscal policy ineffective, central banks should fund fiscal-policy expansion.
Stan Fischer, doyen of mainstream economists, joined the rethink. It was obvious to him (and many others) that monetary policy had lost its power to stimulate the economy. In the post-2008 period, policy interest rates had been lowered to near-zero, and even with real (inflation-adjusted) interest rates clearly negative, entrepreneurs didn’t seize the opportunity of cheap borrowing to expand investment. All that happened was that asset prices were bid up. Fischer saw conventional fiscal policy as ineffective because interest rates would rise to crowd out private expenditure. He advocated ‘helicopter money’ to address the next recession: the central bank should ‘go direct’ in funding what was in effect fiscal policy. Fischer acknowledged that this is a ‘slippery slope’, while asserting that his proposal is quite different from MMT.
"But this is also a slippery slope. A drift away from central bank independence – where the overall monetary policy stance is dominated by short-term political considerations – could quickly open the door to uncontrolled fiscal spending. The risk is real. This slippery slope leads to arguments that monetary policy can finance fiscal deficits – and that there is only a tenuous link between inflation and money-financed deficits, as some proponents “Modern Monetary Theory” (MMT) claim.
The key is that coordination does not require giving up central bank independence. Instead, policy frameworks need to evolve to acknowledge that it is not the response itself that needs to be independent. The policy response in times of crisis will have to involve elements of both fiscal and monetary policy. But the contribution of monetary and fiscal authorities to the response can still be cleanly separated. The approach described below provides a concrete example of how this can be done."
But how different is it really? Money-financed deficits are the proposal, and these are to be used when other conventional instruments are ineffective, and when inflation is not a danger. Doesn’t this sound like MMT? In Fischer’s proposal, the threat of uncontrolled fiscal expenditure is prevented by the decision-making being handed over to a central-bank-like independent committee. It is different from MMT because Fischer acknowledges that this is to be used in special circumstances, and there should be an exit strategy. But if conventional macro-policy instruments are not working in the following recession, why not do this again? And in the recession after that? Fischer talks of the importance of an exit strategy, but unless the conventional instruments can be revived, there is no viable exit in sight.
In the context of this rethink of central bank bond purchases and the role of budget deficits, MMT was well-placed to gain traction: if deficits were effective and central bank bond purchases didn’t cause inflation, MMT views could fill the gap left by the demonstrated failures, or irrelevancy, of the conventional thinking.
3. Then came COVID-19
The immediate response in COVID-affected countries was massive budget deficits combined with central bank actions which, whatever their motivation and objective, involved the purchase of large amounts of government bonds which are, de facto, funding the deficits.
These actions are, in fact, quite different from the QE operations that have become the norm, even though both involve the central bank buying bonds and adding to the base-money supply. When a central bank does QE, it buys a bond from the public and pays for it with cash (base money). It swaps one asset – bonds – for another – base money. No-one has had their income increased in this transaction: the bond seller also just swaps one asset for another. Not much has happened to expand demand, except modest downward pressure on bond yields.
But with money-financed budget deficits, the public receives the cash as a transfer or payment which increases income and hence their expenditure. This fiscal expansion is much more powerful in stimulating the economy than the asset-swap of QE. The much-discussed ‘helicopter money’ is just an example of a money-financed budget deficit – cash is given directly to the public, who will spend most of it, boosting the economy.
Part of the central bank response to COVID has been in the form of QE, but part is in the form of money-financing of the budget deficit. Doesn’t this mean that the MMT strategy has been widely adopted? Far from it, at least according to the mainstream economists. Even those (now quite a few) who advocate policies that look to be close to MMT are adamant that they have not signed up. Why not? What distinctions remain to separate these policies from MMT?
A key issue here is the well-established idea that monetary policy should be clearly separated from fiscal. The conventional idea is that central banks have been given independence because their task – price stability and financial stability -- gets universal and unanimous public endorsement so is not politically controversial. This independence not only gives central banks the ability to carry out the unpopular but sometimes-necessary raising of interest rates (‘taking away the punch bowl just when the party is getting to be fun’), but it also allows central banks to avoid funding budget deficits. This is thought to be so central that some central banks are prohibited by legislation from funding deficits.
Fiscal policy, on the other hand, has to be left in the messy political process because there is no unanimous agreement on the sorts of things that fiscal policy affects – who gets taxed, who gets the benefit of government expenditures and how much government debt is handed on to future generations. With no option of central bank funding, there is a clear constraint on fiscal profligacy – politicians’ largesse is constrained by the need to either raise taxes or fund deficits through bond sales. MMT takes away this constraint and melds monetary and fiscal policy. The widespread concern about MMT is that once this near-free money is available, the political process will squander it on ‘bridges to nowhere’ and populist causes.
Mainstream economists such as Fischer and Turner who advocate money-finance deficits would distinguish their proposals from MMT by asserting that theirs are once-off remedies in response to special circumstances. There would be a clear exit strategy and a time-bound return to a clear distinction between monetary and fiscal policy. MMT proponents see their prescription as being the on-going norm, to be implemented whenever there is unused capacity in the economy.
Post-COVID, this ‘just this one time’ distinction seems naïve. There will be no quick return to budget balance, and the substantial expansion of government debt will be one more factor inhibiting a rise in policy interest rates. Handing over the macro-stability decision to an independent panel formed around the central bank will not resolve the essentially political dilemmas of how much support the government should give to an economy which has been intentionally slowed for medical reasons, with some sectors in an induced coma.
What, then, are the proper limits, and the true constraints, on money-financed deficits? There are three common concerns:
- Budget profligacy
- Financial repression and fiscal dominance
4. Inflation risks
Friedman’s legacy was a wide-spread and firmly-held belief that if the central bank produced excessive base money, inflation was inevitable. This might have been true when Friedman wrote it. The financial sector was heavily regulated, with substantial reserve requirements imposed on the banks. Extra base money allowed them to expand their lending, and there were always eager customers waiting to borrow. If central banks allowed too much borrowing, this might set off inflation.
This was not, however, enough to explain the persistence of ongoing inflation, because this sort of inflation could have been stopped by tighter macro-policies. Inflation persistence came from sustained pressure on capacity (as happens during wartime) or institutional processes that imposed wage/price spirals – strong unions or centralized wage fixing are two examples. Once inflation took firm hold, then the persistence could be maintained by price expectations – everyone expected prices to rise regularly, so producers and wage-setters raised their prices and customers accepted this.
The 1980s, however, saw financial deregulation and institutional changes in wage/price setting. The Thatcher/Regan revolution shifted power away from trade unions. Taming inflation still required a sharp macro-shock to break inflation expectations, but Volcker gave that in the US in 1980 and similar events mimicked this elsewhere: a decade later the ‘recession we had to have’ did the same for Australia.
Inflation targeting, widely adopted in the 1990s, reinforced the stability of price expectations and constrained the economy when it was running too fast.
Early in the 2000s China’s heft as ‘manufacturer to the world’ put a ceiling on price and wage increases everywhere. The lacklustre recovery after the 2008 crisis gave no room for price and wage increases.
Note how irrelevant money is to this inflation story. In this environment, central bank money increases have no inflationary effect. As described above, base money gravitates to banks’ reserve holdings at the central bank. The huge increases in base money created in the US QE operations, and the counterparts in Europe, the UK and Japan, had little discernable effect other than lowering the yield curve.
While-ever the deflationary COVID world is still relevant, inflation is an unlikely concern. Even when COVID is over, Larry Summers’ secular stagnation awaits. Somewhere out there in the more distant future, the low interest rates which have prevailed since 2008 will have to be raised, and when that moment comes, the broad constituency favouring low interest rates (borrowers, including governments and perhaps even central banks with large bond holdings which will incur capital losses) will voice their opposition. But all this is a long way off and other problems might occur first.
5. Budget profligacy
If the central bank is prohibited from financing budget deficits, the budget is disciplined by the need to either raise revenue or sell bonds to fund the deficit. Ease the central bank funding constrain and discipline is eased. This doesn’t mean inflation – remember that MMT restrains the budget deficit to contain inflation. Thus it’s not as if MMT necessarily leads to a much larger government sector. In an economy with a dynamic private sector, government expenditure might be smaller. But in the post-2008 economy, and even more so in the COVID economy, the government is going to play a bigger role, even if decisions are made by the all-knowing central-bank-like independent controller. Perhaps this all-wise committee could just set the budget deficit size, and leave it to parliament to make the hard decisions on distribution and on the size of the public sector by setting taxation rates.
This would certainly give the independent committee a more challenging role than the central bank has at present, but not essentially different from what they do now. Instead of setting the short-term interest-rate instrument to keep the delicate balance between full employment and inflation, the independent committee would set the size of the money-funded deficit to do the same job. The bond-market vigilantes would no longer be relevant as interest rates don’t rise, so one form of budget discipline is gone. But provided the committee is wise and independent, it just might work.
Thus it is hard to dismiss MMT simply on the grounds that it would inevitably lead to budget profligacy. Big spending governments would still be constrained by the capacity of the economy to produce without setting off inflation. The danger of MMT is that the implicit promise of free and debt-less expenditure might in practice over-ride this inflation constraint. The independence of the deficit-setting process might be sorely tested.
6. Financial repression/fiscal dominance
Why is this kind of money-financed deficit more distortionary than simply funding the budget shortfall by selling bonds to the public? The base money created by the money-financing will be held in part by the public as currency. The residual base money that the public doesn’t want to hold, flows to the banks as reserves. The banking system, as a whole, must hold all this residual base money. Individual banks may shift the base money among themselves, buying bonds or lending to other banks. But there is no alternative holder other than another bank. Relative interest rates will change so that each bank’s holdings are voluntary. This is the portfolio balancing process which gives QE its effectiveness in pushing down the bond yield curve, ensuring that money-funded deficits will keep interest rates down. This imposition of extra base money holding on the banking system has some similarities to the former practice of imposing a substantial required-reserve ratio on the banking system (although in that case all banks are forced to take a share of the excess base money).
Just as the old reserve requirements came to be seen as imposing a competitive burden on the banking system which encouraged financial intermediation to shift to the non-bank institutions, money-financing of the budget deficit would, if used very extensively, mean that banks’ reserves became a large part of banks’ assets, probably crowding out normal lending to the private sector. Intermediation would shift to other institutions, as it did in the immediate pre-deregulation period in the 1980s. Banks might lose their key role in the interest-rate setting process that is the heart of current monetary policy.
All this is a far-off concern. The volume of money-financed deficits so far is a tiny part of the banks’ balance sheets. Even in Switzerland, where base money is over three times GDP, the banking sector is so large that the abnormal reserve holdings are not large enough to create serious distortion. But just as the required reserve ratios imposed on banks came to be seen as unsustainably distortionary, money-financed deficits have the same potential to be over-used.
There is a further distortion that in practice may be far more important. All these forms of central bank bond purchase (both QE and money-funded deficits) serve to push interest rates below their normal equilibrium levels. This has distributional effects and means that a key price – the interest rate – is significantly away from its equilibrium level for a sustained period. Interest rates are the key variable in conventional macro-economics, affecting both savings and investment. And this key price is distorted by central bank bond purchases. Savings and investment decisions, pension management, and financial market calculation of asset prices, all depend critically on the input of a sensible and relevant interest rate. Current interest rates, negative in real (inflation-adjusted) terms, cannot be the long-term equilibrium. This may turn out to be the main down-side not only of MMT, but of the post-2008 central bank policies.
MMT proponents must feel that their moment has arrived at last. The core elements of their proposal are being more widely accepted by mainstream economists and now, with COVID, being put into practice. Big deficits are being rolled out everywhere, partly funded by central bank money creation. Debt hawks and inflation alarmists have largely gone silent, and the bond-market vigilantes are no-where to be seen. The MMT promise of free funding for deficits has turned out to be almost true because interest rates are so low and expected to remain so for the foreseeable future. Their view that inflation is caused by running the economy ‘too hot’, rather than by excessive money creation, is now more widely accepted.
MMT views have fallen on receptive minds in the US political process, as left-of-centre ideas were promoted, particularly by Democratic candidates over the past five years.
These are radical changes in the economic orthodoxy, compared with three decades ago. But strongly entrenched scepticism about the MMT message means that MMT cannot claim victory in the sense of converting mainstream economists to the MMT views. It was events – particularly the 2008 crisis, its limp recovery and the impotence of monetary policy – that caused a rethink of macro-economics among some of the most influential mainstream economists. As the mindset of these conventional economists asymptotes closer to the MMT message, these resisters might revive the old put-down: ‘this MMT proposal is both original and correct; but what is correct is not original, and what is original is not correct.’ But they might have to acknowledge that policy prescriptions have largely converged.
The original article can be viewed on the Eureka Report website here.
 Banks’ excess reserves rose from almost nothing at the beginning of 2008 to $2.4 trillion by 2014.